978-0136115274 Chapter 1 Lecture Notes

CHAPTER 1

BUSINESS: WHAT’S IT ALL ABOUT?

CHAPTER OVERVIEW

The chapter begins with a discussion of the purpose of a business, including a discussion of both

for-profit organizations and not-for-profit organizations. Next, the nature of business operations

is discussed. The four types of businesses are discussed: service, merchandising, manufacturing,

and financial services. The first part of the chapter concludes with a discussion of the general

forms of business ownership: sole proprietorships, partnerships, and corporations, including the

advantages and disadvantages of each.

The second part of the chapter begins with a discussion of business activities and the events,

resources, and agents affecting business transactions.

The third part of the chapter discusses the nature of information in general and accounting

information in particular. The users of accounting information are discussed, including

management, regulators, creditors, and investors.

The last part of the chapter is an introductory discussion of the four basic financial statements

(each financial statement is discussed in detail in later chapters). The balance sheet is introduced,

along with the accounting elements: assets, liabilities, and shareholders’ equity. Next, the income

statement is introduced, along with the accounting elements: revenues and expenses. The

statement of changes in shareholders’ equity is then explained, including the common causes for

changes in the equity accounts. Lastly, the statement of cash flows is introduced and compared

with the information presented on the income statement.

At the end of the chapter, there is a short discussion of general business risks, including general

strategic risks, operating risks, financial risks, and information risks.

LEARNING OBJECTIVES

After completing Chapter 1, your students should be able to:

1. Describe what a business does and the various ways a business can be organized.

2. Classify business transactions as operating, investing, or financing activities.

3. Describe who uses accounting information and why accounting information is important

to them.

4. Identify the elements and explain the purpose of the four basic financial statements

—the income statement, the statement of changes in shareholders’ equity, the balance

sheet, and the statement of cash flows—and be able to use basic transaction analysis to

prepare each statement.

5. Identify the elements of a real company’s financial statements.

6. Describe the risks associated with being in business and the part that ethics plays

in business.

CHAPTER OUTLINE

Purpose and Organization of a Business (LO 1)

I. A business is formed to provide goods or services for the purpose of making a profit for

its owner or owners.

II. To start a business you need capital.

a. Capital is the name for the resources used to start and run a business.

b. Capital comes from investors (owners).

c. Capital comes from creditors (lenders).

III. Businesses can be classified as a for-profit organization or a not-for-profit organization.

a. A for-profit firm has the goal of making a profit for its owners.

b. A not-for-profit firm has the goal of providing goods or services to its clients.

IV. Both types of organizations add value—something customers are willing to pay for.

Teaching Tip

Use Exhibit 1.1 to explain the concept of adding value.

The Nature of Business Operations (LO 1)

I. The operation of the business depends on what it is organized to do.

II. There are four types of businesses.

a. Service organization – does something for its customers.

b. Merchandising business – sells a product to its customers.

i. Wholesale company – buys goods, adds value, and then sells them to other

companies.

ii. Retail company – buys goods, adds value, and then sells them to customers

who consume them.

c. Manufacturer – makes the products it sells.

d. Financial services firm – deals in services related to money.

Teaching Tip

Ask the students to suggest examples of each type of business: service, merchandiser,

manufacturer, and financial services. Point out that many businesses are combinations of one or

more types.

Ownership Structure of a Business (LO 1)

I. Business ownership usually takes one of three forms:

a. Sole proprietorship – a company with a single owner.

i. Not separate from its owner in terms of responsibility and liability.

ii. The business is the owner and the owner is the business.

b. Partnership – a company owned by two or more individuals.

i. Similar to a sole proprietorship.

ii. Not separate from the owners in terms of responsibility and liability.

c. Corporations – a special legal form for a business in which the business is a legal

entity separate from the owners.

i. Can have a single owner or a large number of owners.

ii. Ownership in a corporation is divided into units called shares of common

stock.

iii. Owners are called shareholders or stockholders.

iv. Stock exchange – a marketplace where buyers and sellers exchange their

shares of stock. Also called a stock market.

v. The Securities and Exchange Commission (SEC) – the agency that

monitors the stock market and the financial reporting of the firms that trade in

the market.

vi. Advantages of a corporation include diversification and limited liability.

vii. Disadvantages of a corporation include separation of management and

ownership and double taxation of corporate income. Dividends are the

earnings of a corporation distributed to the owners of the corporation.

Teaching Tip

Discuss with the students the advantages and disadvantages of each form of business ownership.

Business Activities and the Flow of Goods and Services (LO 2)

I. An entrepreneur is a person who starts a business.

II. Each step in the process of developing a business is classified as an exchange – who gets

what and who gives what in return. Exchanges are also called transactions.

III. A transaction is classified as:

a. Operating – related to the general operations of the firm.

b. Investing – related to buying and selling items that the firm will use for longer than a

year.

c. Financing – those transactions that deal with how a business gets its funding.

IV. An exchange or transaction involves who gets what and who gives what in return.

V. When an owner invests in the business, it is called a contribution or contributed capital.

a. Contributed capital is an owner’s investment in a company.

b. The business gives ownership.

c. The business gets capital.

VI. When a business repays a loan, it gives the economic resource of cash to the lender. This

amount includes the amount of the loan, called the principal, plus interest, which is the

cost of borrowing money.

Teaching Tip

Use Exhibit 1.3 to illustrate how a business works.

Information Needs for Decision Making in Business (LO 3)

I. Information is needed for decisions, such as:

a. How to finance the business?

b. What type of business organization to use?

c. Purchase/acquisition decisions.

d. Sales/collection decisions.

Teaching Tip

Ask students how a business comes up with the funds to acquire additional assets. Lead students

to see that a company can borrow (liabilities), or use invested funds (shareholders’ equity), or

hopefully, earn it (also shareholders’ equity). Later, you can associate the terms “paid-in capital”

and “retained earnings” with the latter two. Students may say that a company buys other assets

with cash; however, remind them that this would not change total assets.

II. An operating cycle begins with cash, converts cash to inventory, sells the inventory, and

turns the inventory sales back into cash.

III. Accounting information provides information about:

a. Revenue – the amount the company has earned from providing goods or services to

customers.

b. Expenses – costs incurred to generate the revenue.

c. What goods are left at the end of the period.

Teaching Tip

Use Exhibit 1.4 to illustrate the operating cycle.

Who Needs information About the Transactions of the Business? (LO 3)

I. Management

i. Information about what the business has done.

ii. Information about what the business is currently doing.

iii. Information about where the business is going.

II. The financial statements are based on a set of guidelines called generally accepted

accounting principles (GAAP).

a. The Securities and Exchange Commission sets the rules for corporations that trade on

public stock exchanges.

Teaching Tip

Point out that the SEC only has authority over the accounting rules of public companies—those

whose stock is traded on a public exchange.

b. The SEC has delegated much of its responsibility for setting financial standards to the

Financial Accounting Standards Board (FASB). The FASB is a group of

professional business people, accountants, and accounting scholars who have the

responsibility of setting current accounting standards.

c. The Public Company Accounting Oversight Board (PCAOB) is a group formed to

oversee the auditing profession and the audits of public companies.

d. The International Financial Reporting Standards (IFRS) are international

guidelines for financial reporting, used in many places around the world.

e. The International Accounting Standards Board (IASB) is the group that sets

international financial reporting standards.

Teaching Tip

Use Exhibit 1.5 to illustrate the relationships between the groups responsible for financial

reporting.

III. The Internal Revenue Service (IRS) is the federal agency responsible for federal tax

collection.

IV. A certified public accountant (CPA) is someone who has met specific education and

exam requirements set up by individual states to make sure that only individuals with the

appropriate qualifications can perform audits. To sign an audit report, an accountant must

be a CPA.

Overview of the Financial Statements (LO 4)

I. Four basic financial statements:

a. Balance sheet

b. Income statement

c. Statement of changes in shareholders’ equity

d. Statement of cash flows

II. The notes to the financial statements are the information provided with the four basic

financial statements that describes the company’s major accounting policies and provides

other disclosures to help external users better understand the financial statements.

III. Balance sheet

a. The balance sheet shows the accounting equation in detail.

b. It has three parts – assets, liabilities, and shareholder’s equity.

c. Describes the financial position of the company at a specific point in time.

d. Assets

i. Things of value owned by a business

ii. Provide future benefit

iii. Someone has a right (or claim) to the asset

e. Liabilities

i. Claims to the assets by creditors

ii. Amounts owed to those who have loaned to the company

f. Shareholders’ equity

i. Claims to the assets by the owners

ii. Also called net assets (Assets – Liabilities)

iii. There are two types – contributed capital and retained earnings.

iv. Retained Earnings is the total of all net income amounts minus all

dividends paid in the life of the company.

g. Accounting equation illustrated by the balance sheet

i. Assets = Claims

ii. Assets = Liabilities + Owners’ Equity

h. Heading

i. Name of the company

ii. Name of the financial statement

iii. Date (one specific date)

iv. Fiscal year is a year in the life of the business. It may or may not

coincide with the calendar year.

i. Comparative balance sheets are the balance sheets from consecutive fiscal years for

a single company.

Teaching Tip

Explain the balance sheet as a “snapshot” or “still-frame” photo of the business.

Teaching Tip

Use Exhibit 1.7 to illustrate how transactions affect the accounting equation.

IV. Income statement

a. Also known as statement of earnings, statement of operations, or profit and loss

statement.

b. The income statement shows all revenue minus all expenses for an accounting

period – a month, a quarter, or a year.

c. Net income equals all revenues minus all expenses for a specific period of time.

Teaching Tip

Explain the income statement as a “video” or “movie” of the business.

V. Statement of changes in shareholders’ equity

a. Statement of changes in shareholders’ equity starts with the beginning amount of

contributed capital and shows all changes during the accounting period. Then the

statement shows the beginning balance in retained earnings with its changes. The

usual changes to retained earnings are the increases from net income and the

decreases for dividends paid to shareholders.

b. Retained earnings are the total of all net income amounts minus all dividends paid in

the life of the company.

c. Retained earnings are not the same as cash.

d. Contributed capital

Additions – additional investments by owners.

i. Deductions – not covered in this course.

e. Retained earnings

i. Additions – net income

ii. Deductions – dividends

f. Statement of changes in shareholders’ equity is the bridge from the income statement

to the balance sheet

VI. Statement of cash flows

a. Statement of cash flows shows all cash collected and disbursed during a period of

time. Each cash amount is classified as one of three types.

b. Cash from operating activities are cash transactions that relate to the everyday,

routine transactions needed to run the business.

i. Inflows – cash received from customers.

ii. Outflows – cash routinely paid to produce and sell goods and services.

c. Cash from investing activities are transactions involving the sale and purchase of

long-term assets used in the business.

i. Inflows – cash received from selling long-term productive assets.

ii. Outflows – cash paid to acquire long-term productive assets.

d. Cash from financing activities are transactions related to how a business is financed.

i. Inflows – cash received from investors (owners) or creditors.

ii. Outflows – cash paid to repay loans and make distributions (dividends) to

owners.

Teaching Tip

As an introduction to this topic, ask students where their money comes from and what they use it

for. Categorize their suggestions as operating, investing, or financing.

1. Operating – salaries/wages from jobs; rent payments, food, etc.

2. Investing – purchasing or selling investments; buying a house

3. Financing – borrowing or repaying money

Or,

Set up three unlabeled columns on the board (or screen, etc.). Ask students to call out any kind of

activity associated with a business. You can drop each item into the appropriate column and then

ask students to come up with names for the columns.

Teaching Tip

Ask students which of the three activities is most important and why. Also ask them whether

they believe cash flows in each area should be a net inflow or a net outflow.

Teaching Tip

Ask students whether they believe a net increase or a net decrease in cash is more desirable.

Teaching Tip

Use Exhibit 1.14 to show how the financial statements are interrelated.

Real Company Financial Statements (LO 5)

I. Publicly traded corporations are ones that sell their stock on the public stock exchanges.

II. All publicly traded corporations must prepare the four financial statements every year.

III. One of the most important filings a company can make is the 10-K. It provides a

comprehensive overview of the business.

IV. The 10-K must be filed using a computer language called XBRL (Extensible Business

Reporting Language). This is a technology that enables firms to report information in a

standardized way that makes the data immediately available and interactive.

Business Risk, Control, and Ethics (LO 6)

I. Part of planning and running a business is identifying risks.

II. Risk is danger, anything that exposes us to potential injury or loss.

a. Risk that a product failure will result in death of consumers

b. Risk that someone will steal assets from the company

c. Risk that poor quality inventory will be purchased and sold

III. Risks relate to all aspects of the business.

a. General strategic risks – should we market our cigarettes to teenagers?

b. Operating risks – should we operate without a backup power supply?

c. Financial risks – should we borrow money or obtain investors?

d. Information risks – should we use a manual accounting system?

IV. Why take risks?

a. Every risk has a potential reward.

b. Controls are activities performed to minimize or eliminate certain risks.

Teaching Tip

Ask students to describe examples of risks that relate to a job that they have held.

CHAPTER 1 NAME ___________________________________

TEN-MINUTE QUIZ Section _____________ Date____________

_____________________________________________________________________________

_

_____ 1. The primary purpose of a business is to:

a. Pay taxes to the IRS

b. Sell a product

c. Sell goods and/or services to make a profit for the owner(s)

d. Help others

_____ 2. Sources of capital include:

a. Owners (investors)

b. Creditors (lenders)

c. Both A and B

d. None of the above

_____ 3. All of the following are types of for-profit businesses, except:

a. Merchandising companies

b. Service companies

c. Financial service companies

d. Charitable organizations

_____ 4. What is the name of the group that has much of the responsibility for setting

financial standards?

Public Companies Accounting Oversight Board

Financial Accounting Standards Board

Securities and Exchange Commission

None of the above

_____ 5. A business may be organized as a:

a. Corporation

b. Sole proprietorship

c. Partnership

d. Any of the above

_____ 6. A repayment of the principal of loans to creditors would be shown on the

statement of cash flows as a(n):

Operating activity

Investing activity

Financing activity

Revenue activity

_____ 7. Every business transaction is made up of:

a. Resources

b. Agents

c. Events

d. All of the above

_____ 8. The balance sheet contains information about:

a. Revenues and expenses

b. Cash inflows and outflows

c. Assets, liabilities, and equity

d. All of the above

_____ 9. The income statement provides information about:

a. The financial position of the company at a point in time

b. The financial position of the company for a period of time

c. The amount of cash generated by operations

d. The performance of the company for a period of time

_____10. Which of the following financial statements reports the financial position of a

company?

a. The statement of cash flows

b. The statement of changes in owners’ equity

c. The balance sheet

d. The income statement

ANSWER KEY – CHAPTER 1 – TEN-MINUTE QUIZ

C

D

B

D

C

D

C

D

C